Understanding Investment Risk

INVESTMENT RISK

The objective of investing is always to grow your capital, and get the best return you can. However, there is a very important element to consider investment risk.  Most investments carry with them the possibility (sometimes high and sometimes low) of you losing money. With equities, the value of your shares can go up or down. So if you invest in equities, you accept the risk that you may lose money. If you invest in bonds, you take the risk that the company may not be able to pay back your initial investment and the agreed interest as well. When you invest in real estate, you accept the risk that the value of the property could fall.

You could decide that you do not want to invest in any of these and keep all your cash in a bank account. But this option also does not mean that you are not taking any risk. There may be less risk of the value of your capital falling, but the interest you will get on your deposit in the bank will be immaterial compared to the value you could lose through inflation.

There is a direct opposite relationship between risk and reward. The lower the risk you accept, the lower the return you can expect to achieve. However, this does not mean that you should always go for the highest risk option. You should always go with the level of risk you are most comfortable with, keeping in mind your investment goals, how long you are prepared to wait for your investment to grow, and how much of your investment you are prepared to lose.

MANAGING RISK

The best way to manage risk is by ensuring that you spread your investment across several companies, asset classes, sectors, and maybe even countries. By placing your capital in different companies, you ensure that if the value of one company drops, the loss may even be offset by good performance of another company.

By investing in different asset classes, you are also able to spread your risk to take advantage of high returns in one asset class and shield yourself against losses in another as the financial environment changes. The same goes for sectors and countries.

Remember that all investments even the ‘safest’ ones involve a degree of risk. So make sure you choose a range of investments that best suits you.

Contact us for advise.

Understanding Asset Classes

An asset class is a group of securities with the same characteristics, especially with regard to risk. There are three main asset classes equities, bonds and cash. Some professionals also add real estate and other commodities like art and gold when discussing asset classes. Apart from varying levels of risk, each asset class also has a different potential for delivering returns in various market conditions.

WHY DO YOU NEED TO KNOW ABOUT ASSET CLASSES?

It is essential that you know the characteristics of the asset that you are investing in, so you are able to adjust your expectations accordingly. The financial landscape is always changing, so knowing about the different asset classes and how they are performing currently can help you plan how to invest your money. You have to understand the risk and rewards characteristics of any asset you want to invest in, and ensure that it is in line with your own needs to make an appropriate decision for you.

TYPES OF ASSET CLASSES

Equities

Equities (also called stocks or shares) are issued by companies and some are traded on the stock market. When you invest in an equity, you buy a share in a company, and become a shareholder. You can make money from equities in two ways: growth of your capital when the share price increases, or you can receive income in the form of dividends. Neither of these is guaranteed and there is always the risk that the share price will fall below the level at which you invested. Also, past performance of a stock does not guarantee future performance. Equities generally are more unpredictable in the short term, but they have historically outperformed other investments.

Bonds

Bonds (also called fixed income or debt) are loan instruments issued by governments and companies to raise money. When you buy a bond, you lend money with the purpose of receiving interest. Bonds usually pay a set rate of interest at regular intervals over a given period, thereby giving you stable returns and steady income, and return your capital after the set period. They are more stable and have lower risk than equities, but typically, also deliver lower return over the longer term. However, they are not all risk-free if you invest in bonds that are not guaranteed by governments in stable economies or companies with a good track record and health, you face the risk of non-payment of both your interest and capital. The value of bonds are sensitive to changes in both interest rates and inflation.

Money Market Instruments

Money Market instruments are relatively safe short-term investments aimed at preserving capital and providing steady income based on general interest rate level. Such investments can be made in treasury bills (government securities), bankers acceptances and commercial papers. Money Market Instruments typically have lower risk and return than equities and bonds, and are usually geared towards investors that are risk averse. However, as they usually offer lower rates of return, they are not advisable for investors that would like to grow their capital in the long term. The best thing about money market instruments is that they are very liquid which means that investors can withdraw their money whenever they want.

Real Estate

Real estate can be land or property. You can invest in real estate to live in or for investment purposes — apartments, rental houses, office buildings and malls all generate income through rents. Values tend to rise and fall more slowly than stock and bond prices. Real estate helps to protect against inflation as property values and rental income typically rise faster than inflation, but is subject to a number of risks including liquidity and marketability.

WHICH ASSET CLASS SHOULD YOU INVEST IN?

Asking the question, “What asset class is the best investment?” is like asking if vanilla is a better flavor than chocolate. There is no correct answer because the best investment actually depends on your personality, preferences, and needs. The specifics of the individual investment also have a lot to do with your investment profile – so what you always need to keep in mind is your investment goals, investment horizon and risk appetite.

Nevertheless, most financial experts agree that the best investment strategy is to spread your investment across broad asset classes to reduce your risk. This is because a fall in the return of one asset class due to market conditions may not affect you as much. You can do this by investing in a mutual fund that invests in the different asset classes, but be sure to choose a fund with a mix (in terms of the ratio invested in each asset class) that is right for you.

Best Time to Start Investing

WHEN SHOULD YOU START?

It is never too early to start. Investing is the smartest way to secure your financial future. The earlier you start, the more time your money has to compound and grow. This simply means that the interest from the money you have invested is put back into your investment, allowing your money to grow faster. Also, people that start early are able to learn and make mistakes early when they have little to lose, while gaining knowledge and experience to help when they have larger sums to invest, increasing their chances of success.

This does not mean, however, that it is ever too late to start investing. You can begin at any time, but the later you leave it, the more committed you have to be to catch up to achieving your goals as you have a shorter period of time to invest. Begin putting money away for your future today!

HOW MUCH DO YOU NEED TO START?

Of course, the right time to invest also depends on your particular circumstances. Contrary to what most people think, investing is not only for rich people with plenty of money; you can get started by investing with just a small amount of money. An ARM Discovery Fund, for instance, allows you to start investing with as little as N10,000.

Investing little and often can considerably increase your returns over the long term. It allows you to take advantage of increases in interest rates and reductions is share prices.

How to Begin your Investment

FACTORS TO CONSIDER BEFORE INVESTING

Before you invest, you need to decide on the best investment option for you. To make this important decision, you should consider your goals for the investment, how long you can afford to tie down your money and how much risk you are willing to bear.

Investment goals

It is important to define your investment goals at the outset, as the choice will depend on the objective you are trying to achieve. Common investment goals are:

  • Planning for your retirement
  • Buying your house
  • Providing for the education of your children or yourself
  • Buying a new car
  • Planning for a wedding or milestone birthday celebration
  • Going on holiday

Investment horizon

It is essential that you have an idea of how long you can leave the money in an investment (or investment fund) account without the pressure to liquidate before realising your objectives. Although mutual funds allow you to take money out at any time, funds that have a high degree of risk are meant for investors who have a long term horizon. This is because these funds typically invest in assets that can be volatile even though they tend to provide inflation adjusted returns over the long term. Therefore, if you invested in these assets for a short term, the risk of not getting your entire investment capital is higher compared to investing over the long-term.

Your investment horizon is fundamentally linked to your investment goals. For example if you are looking at buying a new car in a year, you may want to put your money in a fund that seeks to protect your capital invested and provide regular income.. However, if you are a 30 year old man investing towards a university education for your new born child, you are able to leave your money in a riskier, longer term fund in the expectation that the money will grow in line with inflation to cover the school fees when your child is ready to go to university.

Risk Appetite

Simply put, this means how much risk you are willing to take to get a higher level of return. The more risk you take, the higher the potential for real return, but also the higher the potential to make losses. If you are a risk taker, you may want to invest in a fund that has a higher proportion of investment in equities. However, for someone close to the age of retirement, you may want to stick to safer near cash instruments.

Investment Expertise

If you are an experienced investor, you are able to invest directly in the different asset classes or pick an investment fund using your own knowledge, skill and experience. However, if you are just starting out, it may be advisable to speak to someone for advice. Funds are the easiest way for beginners, as you just need to have a basic idea of financial markets and the professionals will ensure your money is invested in the best possible way for you. Even if you have experience, sometimes it is good to talk to professionals who have access to more market research and other information. Our Investment Center officers are always glad to help if you need financial advice.

HOW TO INVEST

After deciding to invest, you still have to choose how frequently you want to add to your investment and whether you want your interest paid out regularly.

Growth vs. Income

You have to decide whether you would prefer your savings to keep increasing or whether you want regular payments. If you would like to increase your savings, you are advised to reinvest your dividends into your fund. However, if you need to have a steady income for everyday spending or other purposes, you can choose to have your dividends paid out. You can also combine both options.

Lump Sum vs. Regular Savings

You have to decide on how frequently you want to invest, and the amount. If you have a lump sum to invest, you may want to make a one-off investment. However, you can also choose to invest a regular amount from your salary, or just make payments whenever you have excess cash. It is up to you to decide what you can afford and what is realistic for you, keeping in mind your financial situation and investment goals.